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For release on delivery
10:00 A.M., E.S.T.
February 24, 1987

Testimony by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System

before the
Committee on the Budget
United States Senate

February 24, 1987

I appreciate this opportunity to appear before this
Committee today.

As you know, the Federal Reserve submitted

its semi-annual monetary policy report to the Congress last

That report/ which we have distributed to you, describes

in detail our plans for monetary policy, including the Federal
Open Market Committee's ranges for growth of money and credit.
My prepared remarks this morning will be confined to more
general considerations of domestic and international economic
policies within the context'of recent and prospective developments,
The Economic Setting
The current economic expansion —
its fifth year —

now extending into

is already among the longest in peacetime

It is unusual in other respects as well, including

the absence of certain signs of cyclical excesses that often
develop after years of expansion.

For instance, inventories

have been held well within past relationships to sales, and
spending by manufacturers for plant and equipment has, if
anything, been restrained relative to prospective needs.

-2While the overall rate of economic growth has been
rather moderate since mid-1984, averaging about 2-1/2 percent
a year, that growth has been maintained despite strong pressures
on sizable sectors of the economy.

Oil exploration and develop-

ment activity and agricultural prices have both been heavily
affected by worldwide surpluses.

Commercial construction in

many areas is suffering from earlier over-building.


of the country in which those impacts have been particularly
large have thus remained relatively depressed.

Difficult as

those regional conditions have been, however, many of the necessary
adjustments are well advanced and other areas of the economy
have been moving strongly ahead.
More importantly, both the inflation rate and interest
rates, after four years of expansion, are substantially lower
than when the recovery started.

Homebuilding is being well

maintained, and both capital and labor appear available to
support further growth for some time without undue strain on

Certainly, conditions in financial markets, with

-3stock prices exuberant and interest rates generally as low as
at any time since the mid-1970s, appear supportive of new
But if the traditional indicators of cyclical problems
are largely absent, it is also evident that the economy is
struggling with structural distortions and imbalances that,
for us, have little precedent.

Economic activity over the past

two years has been supported very largely by consumption.

That has

been at the expense of reduced personal saving rates that, by
world standards, were already chronically low.

At the same time,

the huge federal deficit is absorbing a disproportionate amount
of our limited savings.
For a time, we have largely escaped the adverse
consequences for financial markets of that insidious combination
of low saving rates and high federal deficits by drawing on
capital from abroad —

the flow of which in 1986 actually

exceeded all the savings by U.S. households.

The other side of

that coin, however, is a massive trade and current account

-4deficit, restraining growth in manufacturing generally and
incentives for the industrial investment that we will need
in the years ahead.
The simple facts are that we are spending more than we
produce and that we are unable to finance at home both our investment
needs and the federal deficit.
sustainable for long —

Those are not conditions that are

not whenf as at present, the influx of capital

from abroad cannot be traced to a surge in productive investment.
It's not sustainable' from an economic perspective to
pile up foreign debts while failing to make the investment that
we need both to generate growth and to earn the money to service
the debts.
It is not supportable politically, as the pressures
on our industrial base are transmuted into demands for protection.
Ultimately it will not be supportable from an international
perspective either, as the confidence that underlies the flow of
foreign savings will be eroded.
Sooner or later, the process will stop.
question is how.

The only

-5The Broad Policy Approach
In concept^ we could shut off the flow of imports by
aggressive, broadbrush protectionist measures.

But the result

would be to drive up the rate of inflation and interest rates
heref to damage growth abroad, and to invite retaliation.
Instead of sustained and orderly growth, we would invite
world-wide recession.
We could try to drive the dollar much lower —


complacently sit back while the market forces produce that

But that too would undermine the hard-won gains

against inflation, and would risk dissipating the flow of
foreign capital we, for the time being, need.

The stability of

financial markets would be jeopardized, and export prospects
could be undercut by adverse effects on growth abroad.
Both of those courses were specifically rejected by the
Finance Ministers and Central Bank Governors at their meeting
in Paris last weekend.
Faced with similar circumstances, many smaller countries
might reasonably embark upon strong austerity programs —


-6sooner or later would be forced to undertake such programs.


doses of fiscal and monetary restraint would be takenf risking
recession in the short run, but also anticipating that exports would
respond vigorously, imports would decline, and their economies
would soon resume growth on a much sounder footing.

But, in the

context of a sluggish growth of the world economy, for the United
States to take that course would entail particularly high risks
and the results would be problematical at best.
There is a reasonable alternative.

It is more

complicated, but at the same time much more promising.
We can draw upon a combination of policy instruments to
encourage the needed adjustments.

Results may take time.

those results will come with greater certainty —


and they should

be consistent with maintaining growth here and abroad, with
progress toward underlying price stability, and with open
That is, in fact, the course on which we collectively are
embarked, and the course that was endorsed at the meetings in Paris.

-7To be sure, its success will require an unusual combination
of disciplinef patience, and international cooperation.


given the stakes not just for the United States but for others,
I don't think there is any real choice.
Important steps have already been taken in the needed

Most obviously, the value of the dollar vis-a-vis

the currencies of other industrialized countries has declined
substantially, placing our industry in a much stronger competitive

The volume of exports is rising, despite relatively

slow growth abroad.

The deterioration in the trade deficit

overall appears to have been stemmed, even if clear evidence
of a reversal is still lacking.

Moreover, while the depreciation

of the dollar inevitably carries in its train rising import prices,
we have been fortunate that the initial impact on the overall price
level was more than offset by falling oil and other commodity

The underlying inflation rate, measured by trends in

wages relative to productivity, has continued to fall.

-8Given the size of the exchange rate adjustments already
made among the major countries, there is a point beyond which
further instability would damage both our objectives and those
of our trading partners*

Against that background, the Ministers

and Governors of the leading industrialized countries collectively
agreed last weekend that "their currencies [are] within ranges
broadly consistent with underlying economic fundamentals3* on
the assumption certain broad economic policies are carried out*
Vie have been fortunate that the flow of capital from
abroad, buoyed by the rising stock and bond markets here
and by .some declines in interest rates abroad, was well
maintained as the dollar depreciated.

Nevertheless, as we succeed

in reducing our current account deficit, the net capital inflow
will decline as well*

That emphasizes the critical importance

of one of the policy assumptions referred to in the weekend
statement —

that the United States move ahead with further

reductions in the federal budget deficit which absorbs so much
of our own savings.

-9The progress bsing made in that direction this year
. s heartening*

But that can only be a start.

The projected

reduction of $40 to $50 billion this year is from a record high
deficit of more than $220 billion in fiscal 1986 —

more than

5 percent of the GNP -- and it is being assisted by some
temporary factors,

Progress next year will be harder.

Success in my mind will require a reasonably steady
downward pace in the deficit as the economy grows -— and that
progress will need to be maintained by measures that can be
sustained* year after year*

Failing that, it's hard to see how

a sustained decline in the trade deficit* if possible at all in
the face of huge budget deficits, will bring net benefit to the

The clear implication would be congested capital

markets, higher interest rates? strong inflationary dangers,
and threats to growth.

-10International Consistency
Inevitably, because we loom so large in the world
economy, marked improvement in our trade balance will be
matched by noticeable deterioration elsewhere.


that should take place largely in the major countries with
exceptionally large surpluses —

notably Japan and Germany,

both of which are now experiencing some decline in real net

That process cannot take place smoothly and effectively

unless those countries and others are able to maintain a strong
momentum of internal demand*
For years, those countries have been dependent for
growth mainly on high and rising export surpluses*

In both

instances, some shift toward domestic demand was apparent in
1986, encouraged partly by some relaxation of monetary policies.
That points in the needed direction.

Again, the Paris statement

provided an indication of the intent of Japan and Germany, along
with others, to sustain growth by stimulating domestic demand if

-11What is critical from a world perspective is not the
precise nature of these measures or their exact timing, but that,
at the end of the day, those countries are successful in
maintaining a strong momentum of growth even as they absorb
more imports from the rest of the world.
Some newly industrialized countries also have clear
responsibilities for contributing to a better world balance.
Taiwan and Korea, in particular, have or are building external
surpluses that are large even by the standards of the traditional
industrial powers.

Part of that reflects a strong competitive

position, but both also maintain a strong wall of protectionist

The very strength of their external positions points

in the interests of their own citizens as consumers, as well as
of world equilibrium —

to the need for more forceful action to

increase imports, whether by reducing tariffs, by lifting other
trade restrictions or by exchange rate changes.
Success in these efforts, I must emphasize, will not
necessarily or primarily be measured by changes in our own


-12bilateral trade vis-a-vis particular countries*

An open

competitive trading order is by its nature multilateral, and we
and others should judge equilibrium in a world-wide context.
In that connection? most of the developing world,
already carrying heavy debt burdens, is in no position to
revalue currencies or to absorb much higher imports (from the
United States or from others) without, more or less parallel
increases in their exports*

In recent years, however, it has

been the United States that has, in fact, absorbed the great
bulk of what increase in exports Latin America has had —


exports to Europe arid Japan have apparently increased little if
at all*
For us to close our markets to them now would assuredly
thwart prospects for expansion, and with it the encouraging
progress that has been made toward both more open, competitive
economies and political democracy.

What is needed instead is

greater access by those countries to growing markets in Europe
and Japan as well as here.

The recent changes in exchange rates

-13in the industrial world certainly provide greater incentives
for exports of the developing countries to shift to Europe and

At the same time, imports by the developing world from

the United States have become much more price competitive than
a year or two ago.
The_Debt 5 i tuation
I cannot neglect emphasizing one further continuing
threat to growth and financial stability involving the developing

Management of the debt problems of Latin America and

some other developing countries is again at a critical stage*
reason is not that progress is absent.


To the contrary, most of

the heavily indebted countries have been growing -— if for the most
part far below their potential —

debt burdens are tending to

move lower relative to exports or other measures of capacity to
pay, and new financing needs have been reduced.

Perhaps most

encouraging, there has been definite, if sometimes hesitant,
progress toward liberalizing trade, opening markets, and reducing
internal economic distortions, with the World Bank playing a
particularly helpful role.

-14At the same time, any failure of the industrialized countries
collectively to achieve a satisfactory rate of growth would clearly
impair prospects for the developing countries to find the markets
they need.

More immediately/ in recent monthsf the process of

reaching agreement on adequately supportive and timely financing
programs, whether by restructuring existing debts or by arranging
what new loans are necessaryf has conspicuously slowed.
Now, the largest of the debtor countries, Brazil, after
a period of strong expansion, large trade surpluses, and greater
price stability, is again experiencing pronounced inflationary
pressures and economic difficulties.

Its suspension of most

external interest payments to private creditors underscores the
urgency of coming to grips with its internal economic difficulties
as well as developing an appropriate financing program.

I suspect

the very fact that progress has been made over the past five years
until recently in Brazil as in a number of other countries and
most evidently in reducing the exposure of banks relative to
capital to something like half of what it was in 1982 —

has had


-15the unfortunate effect of dulling a sense of urgency and cooperation
in dealing with the remaining problems.
the progress.

I do not want to deny

But to fail in carrying through on past efforts or

in dealing with the new points of strain would plainly jeopardize
past successes and threaten new strains on the financial system.
Implications for U.S. Policy
Several key implications of all this for the United
States should be clear.
Firsts the process of restoring external balance requires
first of all that we tend to our inescapable responsibilities
to deal with our budget deficit.

That is not just because we

are dangerously dependent on foreign savings but because progress
abroad is, as a practical matter, likely to be stymied without
constructive leadership from the largest and strongest nation.
Should we instead resort to closing our markets, be indifferent
to depreciation of our own currency, and permit inflationary
forces to regain the upper hand, then there would be no basis
for confidence in the United States.

Prospects for effective

-16complementary action abroad, or for growth for the world economy,
would be dim indeed*
Second, we have to recognize that the needed adjustments
will require a relative shift of financial and real resources
into internationally competitive industry and away from consumption
and federal deficits.

Without a sharp rise in overall productivity

from the one percent or so rate characteristic of most of the
1970s and 1980s —

and I see no reason to suggest that trend

will change abruptly —

the'recent rate of increase in consumption

is simply unsustainable for long.

Instead, more of our growth

will need to be reflected in net exports and business investment,
and less savings will be available to finance government.
Fortunately, performance with respect to productivity
growth and restraint on costs in the key manufacturing sectors
has been relatively strong during the period of economic

That reinforces prospects for a stronger competitive

position internationally.

The challenge will be to maintain

that performance in the face of a depreciated currency, higher

-17import prices, and more sizable needs for new investment to
meet domestic and export opportunities.
Finally, achieving these goals in the context of
sustained growth and reasonable price stability is beyond
the capacity of any single policy instrument.

Quite obviously,

monetary policy will have a critical role to play.

In doing so,

it has the potential advantage of more flexibility than other
policy instruments.

But there will also be a heavy premium on

maintaining discipline and sound judgment amid potentially
conflicting criteria.
Monetary Policy
Looking back, monetary policy has accommodated a
relatively rapid growth in the various monetary aggregates for
some time? in 1986, the discount rate was reduced four times
by a total of 2 percentage points, more or less in line with
reductions in market interest rates.
This generous provision of reserves and expansion in
money took place in, and appeared justified by, an environment

-18of restrained economic growth and declining inflationary

The latter, to be sure, was dramatically and

importantly reinforced by a temporary factor —

the sudden

collapse in the price of the world's most important commodity,

But, potentially more lasting indicators of inflationary

pressure —

the rate of increase in workers' compensation

and in prices of some services that respond slowly to changes
in the economic environment —

were also trending downward.

For much of the year, most commodity prices other than oil,
measured in dollars, were falling despite the depreciation of
the dollar in the exchange markets.

Moreover, the sizable

declines in long-term interest rates seemed to reflect some
easing of fears of a resurgence of inflationary pressures in
the future.
Nonetheless, the possibility of renewed inflation
remains of concern both in the markets and within the Federal

One potential channel for renewed inflationary pressures

would be an excessive fall of the dollar in the exchange markets.

-19Moreover, the continuing rapid expansion of debt
throughout the economy —
growth since 1982 —

running far above the rate of economic

has raised one warning flag*

The implicit dangers should be clear.

More leveraging of

corporations, aggressive lending to consumers already laboring
under heavy debt burdens, and less equity in homes all increase
the vulnerability of the economy to economic risk —
interest rates, to recession, or to both.

to higher

The fact that, after

four years of expansion, many measures of credit quality are
tending to deteriorate rather than improve, and that too many
depository institutions are strained, should be warning enough.
As we look ahead, the Federal Reserve remains highly
conscious of the long historical patterns that relate high
rates of monetary growth over time to inflation.
In 1987, the effects of the depreciation of the dollar
and the rebound in oil prices are very likely to be reflected in
somewhat larger increases in consumer prices than last year.
What is critical is that such a bulge in prices related to

-20identifiable temporary external developments not be translated
into a broad-based cumulative upward movement.

As you well

know, just such a cumulative inflationary process started in
the 1960s and then extended well over a decade into the 1980s.
It was eventually brought to an end, but only with great effort
and at considerable cost.

The scars of that experience remain.

Against that background, participants both in financial
markets and in business have persistently been skeptical of
prospects for lasting price'stability in making investment and
pricing decisions.

They are bound to be alert and responsive

to any sense of adverse change in the underlying inflation
trend, with implications for interest rates, exchange rates,
and pricing policies.

The consequences for the economy would

clearly be undesirable.
In effect, neither the internal nor external setting
permits thinking of trading off more inflation for more growth.
Nor would inflation ease the problem of international adjustment?
quite to the contrary, it would both undercut some of our

-21competitive gains and threaten the orderly inflow of funds from

Naturally, in the conduct of monetary policy, we will

want to encourage continuing economic expansion.
want to see as long an expansion as possible.

But we also

To that endr the

threat of renewed inflation will require continuing caution to
avoid excessive increases in money and credit.


further sizable declines in the federal budget deficit will
make our job in the Federal Reserve easier.
Concluding Comments
In sum, we face, at one and the same time, most difficult
and most promising economic circumstances.
They are difficult because there are obvious distortions
and imbalances within our economy and internationally.


dealt with forcibly and effectively, those imbalances will impair
both growth and price stability —

and the adverse implications

will be amplified by the effects on other countries.


those imbalances will not yield to any single instrument of
policy, however wisely conducted.

Instead, what is required is

-22complementary actions here and abroad —

on budgets, on monetary

policies, and on maintaining appropriate exchange rates and an
open trading order*
I know none of that is easy.

Many countries are

involved/ and all of them have tough political decisions to

Nor are the key decisions entirely in the hands of

governmental authorities*

American industry, in particular,

has the challenge to build upon the efforts of recent years
toward effective control of -costs and greater efficiency,
and to seek out and exploit the greater market opportunities
that exist today*
From one point of view, it may seem like a lot to ask.
But equally, there is a lot to be gained.
We already have achieved a long economic expansion.
We have managed to combine that with progress toward price
stability —

and that progress has made possible lower interest

Financial markets more generally reflect renewed confidence,

And the broad outline of policies that can preserve and extend
those gains are by now well known.

-23To fail to act upon those policies —

to instead retreat

into protectionism, to relax on inflation, to fail to deal with
the deficit —

may in some ways appear to be the course of least

But those are also precisely the ways by which we

would turn our back to the bright promise before us.
It is only a concerted effort here and abroad that will
extend and reinforce the economic expansion, consolidate the
progress toward price stability, and provide the international
environment in which all countries can prosper.